LegalEASE – Notes from the Legal Experts: What Is a Donor Advised Fund?

LegalEASE – Notes from the Legal Experts: What Is a Donor Advised Fund?

March 13, 2018

A donor advised fund (DAF) is a separate fund or account held and controlled by a 501(c)(3) public charity. The donor or a designee of the donor has advisory privileges over the use of the funds.

The Internal Revenue Code (IRC) defines a DAF as

a fund or account — (i) which is separately identified by reference to contributions of a donor or donors, (ii) which is owned and controlled by a sponsoring organization, and (iii) with respect to which a donor (or any person appointed or designated by such donor) has, or reasonably expects to have, advisory privileges with respect to the distribution or investment of amounts held in such fund or account by reason of the donor's status as a donor. IRC §4966(d)(2)(A).

The public charity that houses and controls the fund is called a "sponsoring organization" and must itself qualify as a 501(c)(3) public charity. Therefore, donations to a DAF are gifts to a public charity, and are thus generally eligible as tax-deductible charitable contributions in the U.S. Sponsoring organizations are often community foundations and nonprofits affiliated with large financial institutions.

In sum, by creating and giving to a DAF, a donor benefits from a tax deduction but relinquishes control over his or her funds, retaining only the right to recommend where and when the funds might be distributed.

DAFs over the Decades

DAFs were not officially introduced to the IRC until 2006, with passage of the Pension Protection Act, which made a number of reforms to the IRC that specifically affected tax-exempt organizations. However, the notion of a charity that accepts funds from donors who make nonbinding recommendations as to where the funds should be donated had been explicitly accepted by a federal tax court as early as 1987. Such organizations had furthermore been operating well before this time.

In National Foundation, Inc. v. The United States of America, the tax court found that a charity, NFI, which had been created "to initiate, fund, and administer a wide variety of charitable, educational, religious, scientific, and literary projects, most of which are recommended by donors," was conducting charitable activities consistent with IRC section 501(c)(3). Key to this finding was the fact that the sponsoring organization — NFI — retained ultimate discretion and control over where funds would be donated. A donor's advice or recommendation was never binding. The court wrote that

NFI does not act as a "conduit" for its donors. A conduit function assumes that the donor maintains control over the donation. The record is replete with convincing evidence that donors relinquish all ownership and custody of the donated funds or property. NFI executes with its donors a standard form of agreement which provides that NFI has control of all donations. NFI is free to accept or reject any suggestion or request made by a donor. However, in accepting a donor's recommendation, NFI is bound by its articles of incorporation which prohibit NFI from applying any funds toward a non-exempt purpose. In addition, once NFI accepts a donation, the donor has no legal recourse against NFI for the return of the contribution should NFI refuse to honor the donor's request. … NFI's methods of operating may be somewhat unique and innovative, but by its approach, NFI offers another way to harness both the sensitivity to local community needs and the charitable creativity of public-minded citizens throughout the country. NFI's goal is to create an effective national network to respond to many worthy charitable needs. … By drawing upon this grass roots network … NFI initiates, funds, and administers many small local charitable projects which would otherwise not be supported. … NFI truly functions in the "spirit of charity." Thus, the Court finds that NFI is operated exclusively for exempt purposes.

This case is noteworthy because its tenets continue to apply to the required operations of DAFs today. Although defined in the IRC, DAFs still await treasury regulations that will further guide their operation.

A Hybrid Charity-Foundation

DAFs are unique in that they are subject to a hybrid of the rules that apply to public charities and those that apply to private foundations. For example, because DAFs are housed in and controlled by public charities, U.S. individual donors are generally allowed the same tax deduction they would receive when giving to any U.S. public charity. On the other hand, DAFs are subject to similar, though not identical, expenditure rules (PDF) as private foundations with respect to disbursements.

Certain additional restrictions and potential penalties apply to grants made out of DAFs, but they are outside the scope of this post.

DAFs and Equivalency Determinations

Under the IRC, DAFs may be taxed on distributions made (1) to an individual, or (2) to an entity that is neither a 501(c)(3) public charity nor its non-U.S. equivalent. In the latter case, a DAF may prevent a taxable expenditure if it obtains an equivalency determination or if it exercises expenditure responsibility. See IRC §4966(c). Therefore, just as with private foundations, DAFs making international grants often choose to conduct equivalency determinations to avoid expenditure responsibility.

In addition, and worth noting, is that while DAFs are prominent in the U.S., they are not unique to the U.S. nonprofit sector. Sponsoring organizations to DAFs exist in countries around the world and often operate in a way that mimics the laws that now define DAFs in the U.S.

NGOsource serves DAF funders who, as NGOsource members, seek to make grants to non-U.S. charities. We also serve non-U.S. charities who themselves operate DAFs and who are selected as potential grantees by NGOsource members. NGOsource has certified a number of non-U.S. sponsoring organizations as equivalent to 501(c)(3) public charities.

DAFs Today … and Tomorrow

DAFs have been, and continue to be, on the rise in the U.S. Currently there are over a quarter of a million individual DAFs that distribute over $16 billion in charitable grants annually.

The IRS has yet to finalize regulations that will provide clearer guidance on their operation. But as we recently reported, in December 2017, the IRS issued Notice 2017-73 (PDF), which proposed and requested comments on several new DAF regulations. The new regulations would, among other things, require that, for public support purposes only, the beneficiary of a DAF grant must "look through" the sponsoring organization. That is, it must treat the gift from the DAF as a gift from the individual donor advisor.

For certain organizations, this could present administrative hardships, and it might mean failing the public support test and therefore not qualifying as a public charity or its equivalent. NGOsource has submitted a comment to the IRS on why we believe this rule could have a disproportionate negative impact on foreign grantees. You can read the full comment here. We will update readers as new developments arise.

Disclaimer: This site provides information to U.S. grantmakers regarding international grantmaking procedures, and should not be construed as a legal service or providing legal advice. As the law differs in each legal jurisdiction and may be applied differently depending on the specific circumstances of each case, the information or use of services on the site should not be used as a substitute for the advice of competent legal counsel.